McDonald’s Corp. (MCD) shares have recently experienced a downturn, largely attributed to investor concerns regarding the impact of high gas prices on consumer spending and, consequently, restaurant sales. However, this market reaction might be an overcorrection, especially as gas prices begin to moderate. This analysis explores McDonald’s underlying value and outlines strategic options for investors looking to capitalize on its potential recovery.
MCD’s Recent Market Performance and Underlying Value
As of Friday, June 26, MCD closed at $269.76, recovering slightly from a recent low of $264.54 on June 25. This is notably below its 3-month peak of $311.36 recorded on April 17. The decline has sparked discussions among analysts about whether the market is unduly punishing the fast-food giant.
Our valuation, based on robust free cash flow (FCF) generation, suggests that MCD stock remains potentially undervalued. Free Cash Flow (FCF) is a critical financial metric representing the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. It’s often considered a strong indicator of a company’s financial health and its ability to generate profits.
Free Cash Flow (FCF) Valuation
Analysts project McDonald’s revenue to be between $28.5 billion this year and $30.17 billion next year, translating to an estimated $29.335 billion over the next twelve months (NTM). Applying McDonald’s trailing 12-month FCF margin of 26%, the company could generate approximately $7.63 billion in FCF.
Utilizing a 3.6% FCF yield, a metric often used to compare a company’s cash generation relative to its market value, we can derive a fair market value (FMV) for McDonald’s:
- $7.63 billion FCF / 0.0359 (FCF Yield) = $212.5 billion FMV.
This calculated FMV is 10.6% higher than McDonald’s recent market capitalization of $191.7 billion (according to Yahoo! Finance). This discrepancy suggests a potential upside for the stock. Based on the current share price, this translates to a price target (PT) of almost $300:
- $212.5 billion FMV / $191.7 billion Current Market Cap = 1.109 (Implied Upside)
- $269.76 (Current Price) x 1.109 = $299.16 PT
Other financial institutions and analysts concur with a bullish outlook, with Yahoo! Finance’s average analyst price target at $330.94, Barchart’s at $330.59, and AnaChart’s at $351.90. However, investors should be aware that such targets are not guaranteed and are subject to market volatility and unforeseen economic factors.
Strategic Options Trading for MCD Stock
Given the potential for undervaluation, investors can consider various options strategies to leverage their position in MCD. One approach involves combining selling out-of-the-money (OTM) puts with buying in-the-money (ITM) calls.
Selling Out-of-the-Money (OTM) MCD Puts
Selling OTM puts allows an investor to generate immediate income (premium) by agreeing to buy shares at a specified strike price if the stock falls below that price by expiration. This strategy effectively sets a lower potential entry point for buying the stock while collecting premium income.
For example, consider selling the July 31 expiry $260.00 put option. With MCD closing at $269.76, this strike price is 3.6% out-of-the-money. The midpoint premium for this option is $3.08 per contract. This means an investor receives $308.00 immediately for every 100 shares covered by the contract. This represents an immediate income of 1.185% ($3.08 / $260.00) over the 34-day period until expiration. The initial capital required would be $26,000 to cover the potential purchase of 100 shares at the strike price. If MCD falls to $260.00 and shares are assigned, the net breakeven buy-in price would be: $260.00 (Strike Price) – $3.08 (Premium Received) = $256.92. This is 4.76% below Friday’s closing price.
If an investor can consistently execute this strategy for approximately five months, the cumulative premium collected could significantly offset other investment costs: $3.08 x 6 (months) = $18.48.
Buying In-the-Money (ITM) MCD Calls
An in-the-money (ITM) call option provides immediate intrinsic value and offers leveraged exposure to potential upside. Investors can use the income generated from selling OTM puts to help finance the purchase of ITM calls.
For instance, consider buying a Dec. 18, 2026, expiry $260.00 call option. This call option has a midpoint premium of $23.98. If an investor uses the $18.48 generated from monthly put sales to offset this cost, the net cost of the call option would be just $5.50 ($23.98 – $18.48). This implies a net buy-in point for the underlying stock (via the call option) of $265.50, which is already below the current market price of $269.76.
If MCD reaches our calculated price target of $299.16 by the call option’s expiration, the potential intrinsic value would be $39.16 ($299.16 – $260.00). Given a net call option cost of $5.50, this strategy could yield a substantial leveraged profit: ($39.16 / $5.50) – 1 = 6.12x or 612% profit. This high return, however, is contingent on the ability to consistently sell OTM puts at high premiums over the 6-month period, which is not guaranteed.
In conclusion, McDonald’s stock appears to be at a critical juncture, possibly having hit its bottom. For investors with a bullish outlook, combining out-of-the-money put sales with in-the-money call purchases offers a sophisticated strategy to potentially achieve leveraged returns, assuming favorable market conditions and consistent options premiums.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. This article was originally published on Barchart.com
Frequently Asked Questions (FAQ)
What is Free Cash Flow (FCF) and why is it important for stock valuation?
Free Cash Flow (FCF) represents the cash a company generates after covering its operating expenses and capital expenditures. It’s crucial for stock valuation because it indicates a company’s ability to produce cash for shareholders, pay down debt, or invest in growth without relying on external financing. A higher, consistent FCF often suggests a financially healthy and attractive investment.
How do “out-of-the-money puts” work as an investment strategy?
Selling an out-of-the-money (OTM) put option means you agree to buy shares of a stock at a specified strike price, which is currently below the market price, on or before a certain date. In return, you receive an immediate premium. This strategy is used by investors who believe the stock price will not fall below the strike price, allowing them to keep the premium, or by those willing to acquire the stock at a lower price if it does fall.
What are “in-the-money calls” and how can they provide leveraged returns?
An in-the-money (ITM) call option has a strike price below the current market price of the underlying stock, giving it intrinsic value. Buying ITM calls provides leveraged returns because a small movement in the stock price can lead to a larger percentage gain in the option’s value, as opposed to directly buying shares. This strategy is chosen by bullish investors seeking to maximize gains with less capital outlay, often using income from other strategies (like selling puts) to reduce the net cost.
